Emerging Markets: Concentration and Diversification

05.12.2017

Emerging market equities have been on a storming run over the past year. So far in 2017, the MSCI Emerging Markets index is up 22.4% in EUR, while the MSCI World – a gauge of developed market stocks – is up only 7%. After a multiyear period where EM stocks had underperformed, we see several drivers for their recent strength, and generally belief they remain an attractive asset class.

However the strong performance this year has been based largely on just one sector: tech stocks. The IT sector has gained around 49% so far in 2017, almost 30 percentage points more than the overall market. Even the second strongest sector has gained only 24%. Crucially, this extreme performance gap has been driven by just a few stocks, and it raises serious questions over the nature of concentration and diversification within emerging market portfolios.

Within developed markets, there is often talk of the FANG stocks (Facebook, Amazon, Netflix and Google), but in practice, there is a group of tech stocks which are even more dominant within emerging market stock indexes. A few years ago, the IT sector was just over 10% of MSCI EM, but has expanded to almost 30% today. Six tech stocks dominate: Samsung Electronics, semiconductor player TSMC, and internet names Tencent, Alibaba, Naspers, and Baidu. Those six stocks now make up almost 23% of the index.

To put this in context MSCI EM includes 26 diverse countries, but if Samsung, Tencent, Alibaba and TSMC were countries, each would be a Top 10 nation by index weight. Combined, the Big 6 Tech stocks weigh more in the index than all 20 smallest countries added together – and that’s a list which includes heavyweights like Mexico and Russia. The increase in the IT weight has been driven partly by the MSCI decision in 2015 to include in its EM index some Chinese stocks which are listed in the US – like Alibaba and Baidu – but mainly by the strong performance of these names in recent years. Over the past 5 years, the IT sector has gained 144%, about 120 percentage points better than the overall index.

This may be performance driven, but the benchmark arguably starts to have some potential issues of concentration risk, when such a few stocks become so dominant. Many of the tech stocks are more ‘growth’ than ‘value’, and when we look at the growth segment of the market, the concentration is even more extreme. MSCI EM Growth now has 43% in the IT sector, with significant chunks of that in the big internet names. Meanwhile, MSCI EM Value has only 12% IT weight.

Those differing exposures to the IT sector have a significant impact: in 2017, growth stocks (MSCI EM Growth) are up around 30%, while value stocks (MSCI EM Value) are up just 11%. After such a period, for investors who are heavily exposed to emerging market growth stocks, with significant concentrations in megacap tech stocks, it may be prudent to consider diversification into value stocks. As we have commented elsewhere, value stocks offer an asset class where relative valuations have grown steadily cheaper in recent years, where supportive macro tailwinds may lie ahead, and where active, stock-picking investors find fertile grounds for generating alpha – as our fund has demonstrated over the past 5 years.

As fundamental value investors, we are focussed on the long-term corporate value of individual companies. Our emerging market funds have typically been underweight IT in recent years, and this has been a headwind felt more sharply at certain times when the megacap tech stocks rallied, such as autumn 2017. However, we have generally offset this headwind through strong selection. Over the past 5 years, while the IT sector in general returned around 144%, our IT holdings gained closer to 400%. We typically find it easier to buy hardware and semiconductor related names, which trade at lower valuations, partly due to their cyclicality – and harder to buy internet names, which typically come at much higher valuations. We do like some of these companies, and find the structural growth in their revenues and earnings extremely attractive. When pricing opportunities arise, we may exploit them: for example, we bought a minor position in Baidu in mid-2017 as we felt its valuations lagged fair value. But much of the time, the valuations are too high.

The issue of IT dominance of equity benchmarks will likely continue to be a key theme in emerging markets. We will remain focussed on applying our disciplined investment process to select individual stocks for their potential to drive excess returns over the medium to long-term.

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